1. Chapter 3 Income Statement and Statement of Stockholders’ Equity
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2. Income Statement and Statement of Stockholder’s Equity
Also called the statement of earnings
Presents a firm’s revenues, expenses, net income, and earnings per share
Statement of Stockholder’s Equity
Link between balance sheet and income statement
Annual reports include three years of income statements and stockholder’s equity information.
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3. The Income Statement Comes in two basic formats
Multiple-step format
Single-step format
Multiple-step format should be used for analysis purposes.
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4. The Income Statement Multiple-step format
Provides several intermediate profit measures prior to the amount of net earnings for the period
Gross profit
Operating profit
Earnings before income tax
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5. The Income Statement
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6. The Income Statement Single-step format
Groups all items of revenue together, then deducts all categories of expense
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7. The Income Statement
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8. The Income Statement
Regardless of format, certain items must be disclosed separately on an income statement:
Discontinued operations
Extraordinary transactions
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9. The Income Statement Comprehensive Income
Change in equity during a period from transactions, other events, and circumstances related to nonowner sources.
Companies are required to report comprehensive income in one of three ways:
on the face of its income statement
in a separate statement of comprehensive income, or
in its statement of stockholders’ equity.
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10. The Income Statement Common-Size Income Statement
Useful analytical tool
Compare firms with different levels of sales or total assets
Facilitate internal or structural analysis
Evaluate trends
Make industry comparisons
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11. The Income Statement Common-Size Income Statement
Expresses each income statement item as a percentage of net sales
Shows the relative magnitude of various expenses relative to sales, the profit percentages, and the relative importance of “other” revenues and expenses
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12. The Income Statement
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13. The Income Statement Net Sales
Total sales revenue is shown net of returns and allowances.
A sales return is a cancellation of a sale.
A sales allowance is a deduction from the original sales invoice price.
Sales are the major revenue source for most companies.
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14. The Income Statement Net Sales
If a company’s sales are increasing (or decreasing), it is important to determine whether the change is a result of price, volume, or a combination of both.
The reasons for sales growth (or decline) are covered in the Management Discussion and Analysis.
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15. The Income Statement Net Sales
“Real” (inflation adjusted) sales growth
“Nominal” (as reported) sales growth
An adjustment of the reported sales figure with the Consumer Price Index (or some other measure of general inflation) will enable the analyst to compare changes in real and nominal terms.
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16. The Income Statement Cost of Goods Sold Also called cost of sales
Cost to seller of products or services sold to customers
Affected by cost flow assumption used to value inventory
Largest expense for many firms
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17. The Income Statement Cost of Goods Sold Percentage
Ratio of cost of goods sold and net sales
Important for profit determination
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18. The Income Statement Cost of Goods Sold Percentage – Sage Inc.
Increased between 2014 and 2015
MD&A explains that lower prices on footwear have resulted in lower margins.
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19. The Income Statement
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20. The Income Statement Gross Profit Also called gross margin
Difference between net sales and cost of goods sold
First step of profit measurement on the multi-step income statement
Key analytical tool in assessing operating performance
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21. The Income Statement Gross Profit Margin
Ratio of gross profit to net sales (expressed as a percentage)
Complement of the cost of goods sold percentage
Firms want to maintain or increase gross profit margin.
Remains relatively constant in stable industries
May change significantly in volatile industries
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22. The Income Statement Gross Profit Margin – Sage Inc.
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23. The Income Statement Gross Profit Margin – Multiple Revenue Sources
Each revenue is shown separately.
Each revenue line will show the corresponding cost of goods sold for each revenue source.
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24. The Income Statement
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25. The Income Statement Operating Expense
Includes areas in which management discretion is exercised
Has considerable impact on current and future profitability
Important to track trends, absolute amounts, relationship to sales, and relationship to industry competitors
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26. The Income Statement Operating Expenses
Selling and administrative expenses
Advertising costs
Depreciation and amortization
Repairs and maintenance
Impairment charges
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27. The Income Statement
Operating Expenses – Selling and Administrative Expenses
Relate to the sale of products or services
Salaries, rent, insurance, utilities, supplies, etc.
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28. The Income Statement Operating Expenses – Advertising Costs
Are or should be a major expense when marketing is an important element of success
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29. The Income Statement
Advertising Costs for Sage Inc. Sage Inc. spends 6 to 7 cents of every sales dollar for advertising.
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30. The Income Statement Operating Expenses – Lease Payments
Costs associated with operating rentals of leased facilities for retail outlets
Note 3 to the financial statements explains the agreements that apply to the rental arrangements and presents a schedule of minimum annual rental commitments.
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31. The Income Statement
Operating Expenses – Depreciation and Amortization
Cost of assets other than land that will benefit a business enterprise for more than a year is allocated over the asset’s service life.
Cost allocation procedure is determined by the nature of the long-lived asset.
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32. The Income Statement
Operating Expenses – Depreciation and Amortization
Depreciation is used to allocate the cost of tangible fixed assets.
Amortization is an allocation process applied to capital leases, leasehold improvements, and cost expiration of intangible assets.
Depletion is an allocation process applied to acquisition and development of natural resources.
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33. The Income Statement
Percentage of Depreciation and Amortization Expense for Sage Inc.
Decreased somewhat from 2015 to 2016
New assets were placed in service during for only a part of the year (rendering less than full year’s depreciation and amortization).
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34. The Income Statement Operating Expenses – Repairs and Maintenance
Annual costs of repairing and maintaining PP&E
Should correspond to the level of investment in capital equipment and to the age and condition of fixed assets
Inadequate allowance can impair success.
Should be evaluated in relation to the firm’s investments in fixed assets
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35. The Income Statement
Percentage of Repairs and Maintenance Expense for Sage Inc.
Decreased from 2015 to 2016
Could be a result of having newer fixed assets needing fewer repairs
Could be a choice to delay repairs in order to increase operating profit in the short term
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36. The Income Statement Operating Expenses – Impairment Charges
Recognized to record a decline in value of a long-term asset
May occur in connection with goodwill
Can also be recognized when asset values of PP&E decrease below book value
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37. The Income Statement Operating Profit
Also called earnings before interest and taxes (EBIT)
Second step of profit determination on the multi- step income statement
Measures overall performance of operations
Provides a basis for assessing success of a firm apart from financing and investing activities and separate from tax considerations
Sales revenue less the expenses associated with generating sales
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38. The Income Statement Operating Profit Margin
Ratio of operating profit to net sales
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39. The Income Statement Operating Profit Margin for Sage Inc.
Indicates that Sage Inc. strengthened its return on operations in 2016 after a dip in 2015
Despite the percentage increase in cost of goods sold, Sage Inc.’s percentage of selling and administrative and advertising expenses decreased enough to increase operating profit.
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40. The Income Statement Other Income (Expense)
Revenues and costs other than from operations
Dividend and interest income
Interest expense
Investment gains (losses)
Equity earnings (loss)
Gains (losses) from sale of fixed assets
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41. The Income Statement Other Income (Expense)
Firms that carry debt and equity securities classified as “trading securities” report these investments on the balance sheet at market value with any unrealized gains and losses included in earnings.
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42. The Income Statement Other Income (Expense)
In assessment of earning quality, the analyst should consider the materiality and the variability of the nonoperating items of income.
Gains and losses on the sale of major capital assets
Accounting changes
Extraordinary items
Investment income from temporary investments in cash equivalents
Investment income recognized under the equity method
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43. The Income Statement Equity Earnings
Two accounting methods for investments in voting stock of other companies
Equity method
Cost method
Analysts should be aware of whether a company uses the equity or cost method.
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44. The Income Statement Equity Earnings – Equity Method
Allows the investor proportionate recognition of the investee’s net income, irrespective of the payment or nonpayment of cash dividends
Should be used when the investor can exercise significant influence over the investee’s operating and financing policies
Fits accrual accounting requirements
Distorts earnings when income is recognized and no cash may ever be received
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45. The Income Statement Equity Earnings – Cost Method
Investor recognizes investment income only to the extent of any cash dividends received.
Allows recognition of investment income only to the extent of any cash dividends actually received
Carries an investment account at cost
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46. The Income Statement
Example – Assume that company A acquires exactly 20% of the voting common stock of Company B for $400,000. Company B reports $100,000 earnings for the year and pays $25,000 in cash dividends. For company A, income recognition in the earnings statement and the noncurrent investment account on the balance sheet are different depending on the accounting method.
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47. The Income Statement Cost Method
Allows recognition of investment income only to the extent of any cash dividends actually received:
$25,000 x 0.20 = $5,000
Investment account is carried at cost.
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48. The Income Statement Equity Method
Permits the investor to count as income the percentage interest in the investee’s earnings.
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49. The Income Statement Equity Method
Investment account is increased by the amount of investment income recognized and is reduced by the amount of cash dividends received.
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50. The Income Statement Equity Method Distorts earnings
Income is recognized even though no cash may ever be received.
Assumes that the investor could cause the investee to pay dividends (which may not be true)
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51. The Income Statement Earnings Before Income Taxes / Effective Tax Rate
Earnings before income taxes is the profit recognized before the deduction of income tax expense.
Income taxes paid may differ from income tax expense.
Effective tax rate is the ratio of income taxes to earnings before income taxes.
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52. The Income Statement Sage Inc.’s Effective Tax Rate
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53. The Income Statement Earnings Before Income Taxes / Effective Tax Rate
Noteworthy items that may affect the effective tax rate are net operating losses (NOLs) and foreign taxes.
Users of financial statements need to distinguish between earnings increasing due to core operations versus items such as tax rate deductions.
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54. The Income Statement Special Items
Often one-time items that will not recur in the future
Discontinued operations
Extraordinary gains and losses
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55. The Income Statement Net Earnings Also called the “bottom line”
Represents profit after consideration of all revenue and expense
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56. The Income Statement Net Profit Margin
Ratio of net earnings to net sales (expressed as a percentage)
Shows the percentage of profit earned on every sales dollar
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57. The Income Statement Net Profit Margin for Sage Inc.
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58. The Income Statement Earnings per Common Share
Net earnings available to common stockholders for the period divided by the average number of common stock shares outstanding
Firms with complex capital structure report basic and diluted earnings per common share.
Analysts should consider material changes in the number of common stock shares outstanding.
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59. The Income Statement Comprehensive Income
Reported in one of three ways
On the face of the income statement
In a separate statement of comprehensive income
In the statement of stockholders’ equity
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60. The Income Statement
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61. The Income Statement Comprehensive Income
Foreign currency translation effects
Unrealized gains and losses
Additional pension liabilities
Cash flow hedges
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62. The Income Statement
Comprehensive Income – Foreign Currency Translation Effects
Arise from changes in equity of foreign subsidiaries
Occur as a result of changes in foreign currency exchange rates
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63. The Income Statement
Comprehensive Income – Unrealized Gains and Losses
Cumulative net unrealized gains and losses
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64. The Income Statement
Comprehensive Income – Additional Pension Liabilities
Reported when accumulated benefit obligation is greater than the fair market value of plan assets less the balance of the accrued pension liability account or plus the balance in the deferred pension asset account
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65. The Income Statement Comprehensive Income – Cash Flow Hedges
Derivatives designated as hedging the exposure to variable cash flows of a forecasted transaction
Companies using cash flow hedges must initially report any gain or loss in other comprehensive income and subsequently reclassify the amount into earnings when the forecasted transaction affects earnings.
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66. Statement of Stockholders’ Equity
Important link between the balance sheet and the income statement
Documents changes in the balance sheet equity accounts
Annual reports include three years of stockholders’ equity information
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67. Statement of Stockholders’ Equity
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68. Statement of Stockholders’ Equity
Stock dividends
Issuance of additional shares of stock in proportion to current ownership
Reduce retained earnings account
Stock splits
Used to lower the market price of shares to make common stock more affordable
Reverse stock splits
Occurs when outstanding shares are decreased
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69. Earnings Quality, Cash Flow, and Segmental Accounting
Assessment of the quality of reported earnings is an essential element of income statement analysis.
Cash flow from operations is a key ingredient in analyzing operating performance.
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70. Earnings Quality, Cash Flow, and Segmental Accounting
Segmental data include revenue, operating profit or loss, assets, depreciation and amortization, and capital expenditures by industry components.
These disclosures facilitate analysis of operating performance and contribution by each segment.
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71. Copyright Notice
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.
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